Pressures on external payments and importance of financial savings

In 2011-12, the Current Account Deficit (CAD) will touch a new high. Following on the crisis of 1991, our policy makers set a red line for the CAD at 2% of GDP. It was believed that while obtaining capital flows adequate to finance a CAD of up to 2% of GDP would not pose a problem, at higher levels, financing would be problematic.

The average CAD for the 14 years between 1991-92 to 2007-08 when we ran a deficit was 1% of GDP. In three years, 2001-02 to 2003-04, we had run a current account surplus. In 2008-09, the CAD was 2.3%. It rose to 2.8% and 2.6% in 2009-10 and 2010-11, respectively. In 2011-12 it is likely to be around 3.5% of GDP.

The trade balance - merchandise and services - represents the difference between our aggregate domestic demand and supply. The merchandise trade balance has always been in sizeable deficit, but it has been rising - from 4.7% of GDP in 2004-05 to 9.7% in 2008-09. Though there was some moderation in the merchandise trade deficit in 2009-10 (8.5%) and 2010-11 (7.5%), it is estimated to have shot up in 2011-12 to over 9% of GDP.

Our surpluses in the trade in services flowing from software and related areas rose from 2.0% of GDP in 2004-05 to a peak of 3.6% of GDP in 2008-09, slipping a bit to about 3% in the subsequent years. Thus, while rapid growth in the export of IT-related services has helped to bridge large merchandise trade deficits, the order of increase in the latter was significantly greater than the gains in services sector. This was true even before the 2008 crisis. Thereafter, we know that export of IT-related services has been constrained by weak economic conditions in the West.

Millions of Indians live overseas and remit money home. Private remittance inflow increased from 2.8% of GDP in 2004-05 to 3.9% in 2009-10 and is presently around 3.5% of GDP. A large part of this remittance is linked to the IT-related business through Indians who travel overseas on assignments.

At the same time, the stock of foreign investment in India is rising and therefore so also the size of repatriated capital-related incomes. On balance, the key issue is that, the increase in the merchandise trade deficit is occurring at a pace that is not being offset by the growth of export of services and remittances.

Thus far we have been able to finance the CAD without too much of a problem, helped largely by capital inflows. Up to 2007-08 we have had inflows that were larger than the CAD and hence the foreign currency assets of the RBI expanded. In 2008-09, there was a small drawdown. In 2009-10 and 2010-11, the accretion to reserves were quite small - that is, the capital account surplus was only slightly greater than the CAD. In 2011-12, the accretion may be even smaller. So, for the three most recent successive years, when the CAD has been unusually large, capital inflows have been just about sufficient to provide the necessary financing.

The large capital inflows that we got up to 2007-08 encouraged a view that such large inflows would be a regular part of the landscape. If that inference was correct, it would mean that we ought not to hesitate accepting a much higher CAD than the 2% guideline. However, while it is undoubtedly true that the Indian economy today has the capacity to attract greater capital inflows on a sustained basis than in the nineties, it does not necessarily follow that we can assume that such capital inflows will inevitably follow on enlarged CADs.

In fact, investors draw comfort from an easy financing of the CAD - that is, a sizeable surplus in the capital account over the CAD. And derive discomfort from the obverse. It is self-evident that it is in our interest to create conditions where Indian entities are able to secure capital at more favourable terms - which will be the outcome when investors feel confident.

The opposite happens with discomfort - loans become more expensive and equity is demanded at a lower price. And we should bear in mind that most of our neighbours in Asia do not run such high CAD. In fact, many Asian countries run surpluses on the current account.

The CAD in India has a large idiosyncratic element - that is the huge import of gold. Our CAD in 2010-11 amounted to $44 billion, while the value of import of bullion (mostly gold) was $42 billion, up from $30 billion in 2009-10.

In the current year, while our CAD is likely to expand to $67 billion, the import of bullion is likely to be $59 billion. A part of this goes into the re-export of jewellery, but most of it represents investments made by households. It is hard to escape the conclusion that our woes on the CAD flow to a very great extent from our hugely increased appetite for gold.

Why did this increase happen? My submission is that it was a reaction to high inflation, the weakening rupee, low attractiveness of and poor mobilisation through mutual funds and life insurance policies and rising world gold prices.

Ever since the 1950s, a central focus of policy was to encourage savings in financial instruments which is then available for productive investment by others. However, mobilisation by mutual fund and insurance industries has been weak in recent years.

The inter-connectedness of different elements of the economy is well illustrated by the way in which gold has impacted CAD. The issue of gold is inextricably linked to the vigour of financial instruments to act as a bridge between savers and investors. It is possible to rebuild this bridge. Some steps have been taken and more should follow.